The Federal System

Financial Relations
Between The Union
And The States

No other federal constitution makes such elaborate provisions as the Constitution of India in respect to the relationship between the Union and the States in the financial field. In fact, by providing for the establishment of
a Finance Commission (Article 280) for the purpose of allocating and adjusting the receipts from certain sources, the Constitution has made an original contribution in this extremely complicated aspect of federal relationship. The significance of this provision becomes evident when one takes into account the unending conflicts between the federation and the units in the financial field that characterise the working of the other federations.

Often the federation and the units have tried to raise revenue by taxing the same sources such as income-tax. In theory, it may look right, but in practice it created great inconveniences. The federation thought that the States stood in its way of enhanced taxation, while the States looked upon the federation as a hindrance to their financial soundness. At the same time, the people thought that they were subjected to double or excessive taxation. There was a constant challenge by the States to the authority of the federation to impose a particular tax. At the same time, the federation, too, resorted to the same process against the States. Individual citizens, too, challenged the authority of either the federation or the States so as to suit their interests. The result was an enormous amount of litigation. The Indian Constitution lays down a broad scheme for the distribution of revenue resources between the Union and the States. But it has left the task of detailed allocation to the Finance Commission to be set up by the President within two years after the inauguration of the Constitution.

The basic principles that guide the allocation of resources between the federation and the units are efficiency, adequacy and suitability. It is, indeed, difficult to achieve all the three and at the same time. Constitutional, natural and economic considerations often stand in the way. Even if a certain system might suggest itself as the most acceptable, it would not satisfy the claims and counter-claims of the various States. Hence, the Constitution has attempted a compromise. According to this, the subject is divided into two parts, namely, (1) the allocation of revenues between the Union and the States, and (2) the distribution of grants-in-aid.

Distribution Of Proceeds
Of Taxes/Duties

The distribution of the tax-revenue between the Union and the States, according to the foregoing principles, stands as follows :

(A) Taxes belonging to the Union exclusively :

1.  Customs.

2.  Corporation tax.

3.  Taxes on capital value of assets of individuals and companies.

4.  Surcharge on income tax, etc.

5.  Fees in respect of matters in the Union List (List I).

(B) Taxes belonging to the States exclusively :

1.    Land Revenue.

2.    Stamp duty except in documents included in the Union List.

3.    Succession duty, Estate duty, and Income tax on agricultural land.

4.    Taxes on passengers and goods carried on inland waterways.

5.    Taxes on lands and buildings, mineral rights.

6.    Taxes on animals and boats, on road vehicles, on advertisements, on consumption of electricity, on luxuries and amusements, etc.

7.    Taxes on entry of goods into local areas.

8.    Sales Tax.

9.    Tolls.

10.  Fees in respect of matters in the State List (List II).

(C) Duties levied by the Union but collected and appropriated by the States (Article 268)

Stamp duties and duties of excise on medicinal and toilet preparations (those mentioned in the Union List) are levied by the Government of India, but are collected and appropriated :

(i) in the case where such duties are leviable within any Union Territory, by the Government of India, and

(ii) in other cases, by the States within which such duties are respectively leviable.

(D) Taxes levied and collected by the Union but assigned to the States within which they are leviable
(Article 269)

1.    Duties on succession to property other than agricultural land.

2.    Estate duty in respect of property other than agricultural land.

3. Terminal taxes on goods or passengers carried by railways, sea or air.

4. Taxes on railway fares and freights.

5.    Taxes other than stamp duties on transactions in stock exchanges and future markets.

6.    Taxes on the sale or purchase of newspapers and on advertisements published therein.

7.    Taxes on the sale or purchase of goods other than newspapers where such sale or purchase takes place in the course of inter-State trade or commerce.

8.    Taxes on inter-State consignment of goods.

(E) Taxes levied and collected by the Union and distributed between the Union and the States (Article 270)

1.    Taxes on income other than agricultural income.

2.    Union duties on medicinal and toilet preparations as are mentioned in the Union List and collected by the Government of India.

“Taxes on income” do not include corporation tax. The distribution of income-tax proceeds between the Union and the States is made on the basis of the recommendations of the Finance Commission.

Distribution Of Non-Tax Revenues

The principal sources of non-tax revenues of the Union are the receipts from—

Railways; Posts and Telegraph; Broadcasting; Opium; Currency and Mint; Industrial and Commercial Undertakings of the Central Govern-ment relating to the subjects over which the Union has jurisdiction.

Of the Industrial and Commercial Undertakings relating to Central subjects may be mentioned—

The Industrial Finance Corporation of India; Air India; industries in which the Government of India has made investments, such as the Steel Authority of India; the Hindustan Shipyard Ltd; the Indian Telephone Industries Ltd.

The States, similarly, have their receipts from—

Forests, irrigation and commercial enterprises (like electricity, road transport) and industrial undertakings (such as soap, sandalwood, iron and steel in Karnataka, paper in Madhya Pradesh, milk supply in Mumbai, deep-sea fishing and silk in West Bengal).

(Article 275)

Federalism is not only a unifying, but also a levelling-up force. Among the constituent States of the Union are some which are developed and advanced while others are undeveloped or underdeveloped and backward. One of the results expected of a federal union is the opportunity that it should provide for the socially and economically backward units to better their lot. A common method adopted for this purpose is the system of the Union giving grants to the needy States. Article 275 provides for this by empowering Parliament to pay, out of the Consolidated Fund of India, certain sums every year as grants-in-aid to the revenues of such States, to the extent that such assistance is adjudged as necessary. The grants so fixed are based upon the recommendations of the Finance Commission. It is not necessary that every State should get grants-in-aid every year. If, in the opinion of the Finance Commission, a particular State does not need such assistance, Parliament may leave it out while allocating such grants. The Constitution, however, makes it obligatory for the Union Government to pay such grants-in-aid to cover the schemes of development undertaken by a State with the approval of the Union for the purpose of promoting the welfare of the Scheduled Tribes in that State or raising the level of administration of the Scheduled Areas.

Finance Commission
(Articles 280 and 281)

As has been pointed out earlier, the constitutional requirement of setting up a Finance Commission is an original idea. According to this, the President should, within two years from the inauguration of the Constitution and thereafter on the expiry of every fifth year or at such earlier intervals as he thinks necessary, constitute a Finance Commission. The Commission will consist of a Chairman and four other members who are all to be appointed by the President. As the Commission has to be constituted at regular intervals, a certain measure of continuity in the work of these Commissions is ensured. And each Commission profits by the work of its predecessors.

According to Article 280, the Finance Commission has to make recommend-ations to the President on two specific matters and on “any other matter referred to the Commission by the President in the interests of sound finance.”

It shall be the duty of the Commission to make recommendations to the President as to—

(i) the distribution between the Union and the States of the net proceeds of taxes which are to be, or may be, divided between them and the allocation between the States of the respective shares of such proceeds;

(ii) the principles which should govern the grants-in-aid of the revenues of the States out of the Consolidated Fund of India;

(iii) the measures needed to augment the Consolidated Fund of a State to supplement the resources of the Panchayats in the State;

(iv) the measures needed to augment the Consolidated Fund of a State to supplement the resources of the Municipalities in the State; and

(v) any other matter referred to the Commission by the President in the interests of sound finance.

The President, after considering the recommendations of the Finance Commis­sion with regard to income-tax, prescribes by order the percentages and the manner of distribution. Parliament is not directly concerned with the assign-ment and distribution of income-tax.

The importance of the Finance Commis­sion as a constitutional instrument capable of settling many complicated financial problems that affect the relationship of the Union and the States may be seen from the recommendations of the last 12 Finance Commissions. The present system of allocation of finance between the Union and the States is almost entirely the result of these recommendations.

Viewing the Union-State relationship in the financial field as a whole, one finds that it is in harmony with the general nature of the Indian federalism, namely, the tendency for centralisation. The Union Government is financially stabler and stronger than the State Governments. This was necessary to facilitate the planned development of the country as a whole and to check parochial and even separatist tendencies in the economic activities within individual States. As it is, the States are, in view of their limited resources, bound to look up to the Union for financial aid for most, if not all, developmental projects. Naturally, they will have to follow the lead of the Union and often even submit to its dictates.

Financial Control By The Union In Emergencies

As in the legislative and administrative spheres, so in financial matters, the normal relation between the Union and the States (under Articles 268-279) is liable to be modified in different kinds of emergencies. Thus, (a) while a Proclamation of Emergency [Article 352(1)] is in operation, the President may by order direct that, for a period not extending beyond the expiration of the financial year in which the Proclamation ceases to operate, all or any of the provisions relating to the division of the taxes between the Union and the States and grants-in-aid shall be suspended [Article 354]. In the result, if any such order is made by the President, the States will be left to their narrow resources from the revenues under the State List, without any augmentation by contribution from the Union.

(b) While a Proclamation of Financial Emergency [Article 360(1)] is made by the President, it shall be competent for the Union to give directions to the States—

(i) to observe such canons of financial propriety and other safeguards as may be specified in the directions;

(ii) to reduce the salaries and allowances of all persons serving in connection with the affairs of the State, including High Court Judges;

(iii) to reserve for the consideration of the President all money and financial Bills, after they are passed by the Legislature of the State [Article 360].

Financial relations between the Union and the States, especially in a developing economy, cannot remain static
for long. Adjustments will have to be made in the light of the changing pattern of the economy. Legislative enactments on taxation cannot be made for all times to come. After all, the relationship between the Central Government and the States in a federal system is a dynamic one; and the problems arising out of this relationship cannot be solved once for all any more than the problems of life itself. Following the “autonomy” demand by Jammu & Kashmir Government, the Centre may consider devolution of more financial resources to the State as well as to other States. 

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